There is a well-worn joke in the economics profession that involves two economists – one young and one old – walking down the street together:

The young economist looks down and sees a $20 bill on the street and says, “Hey, look a twenty-dollar bill!”

Without even looking, his older and wiser colleague replies, “Nonsense. If there had been a twenty-dollar lying on the street, someone would havealready picked it up by now.”

The conclusion, of course, is that markets are efficient and if there were large opportunities to profit, someone would have taken them already. Many have used this logic to argue against the notion that energy efficiency is a productive use of capital, while many others have noted that this viewpoint makes no sense at all.

It should be fairly obvious to readers that we here at Financing Efficiency see $20 bills on the ground all the time. Building energy efficiency has vast potential for saving money and the business of saving energy hasn’t even begun to scale yet. But that is neither here nor there. The point of today’s post is to use the $20 bill story as a window into analyzing the barriers to scaling the energy efficiency market.

So let’s take another look at that metaphorical $20 bill lying on the sidewalk. Imagine a building owner walks down the street and walks right by without picking up the bill. Why would that be the case?

Maybe the building owner sees the $20 bill, but is too busy to bend down to pick it up. Or maybe the building owner sees the $20 bill, but doesnt exactly know how to pick it up, and would have to hire a mechanical engineer to do it for him and it doesnt seem worth all the time and effort. Or maybe the building owner doesn’t even see the $20 bill, because it is hidden in the leaky ducts of his ventilation system and just blowing out the window. Broadly, this category of barriers can be summed up as “complexity”. If efficiency is perceived to take too much time, too much effort, or too much uncertainty, owners are much less likely to move forward.

Maybe instead of seeing a $20 bill, the building owner only sees a penny or a dime. Is it really worth the time and effort to pick it up? For the building owner, probably not. Especially if the building owners sees much bigger bills lying around elsewhere, like in lobby upgrades for example. Of course, it’s easy to imagine how someone with a vacuum could make a lot of money from picking up all those pennies or dimes, but that doesn’t mean very much to any given building owner.

Maybe the $20 bill isn’t really sitting on the sidewalk at all. Actually, it’s sitting inside the owners building. So unlike the bill on the street, that is free for anyone to pick up, the bill in the owners building requires the cooperation of the owner. As we’ve mentioned before, without the owner (or at the very least his agent) on board, there is no energy efficiency project. Put differently, there is a big difference between potential and opportunity. Potential is the apparent market size – the value that, say, a McKinsey would see when looking at a market. Opportunity, on the other hand, is the near-term, accessible investment that a building owner could seek to capture. As we and our readers all know, there is enormous potential for energy efficiency, but many building owners have trouble seeing the actionable opportunity. It’s as if the $20 bill were behind a one way mirror, and building owners are only staring at themselves. It’s still there, but only the energy efficiency advocates on the other side can see it. And until the owner sees it and decides to pick it up, it is stranded from everyone.

None of this should be new to any of our loyal readers. But the $20 bill story is useful for thinking about efficiency because it strips away a lot of the fluff around energy efficiency and allows for the focus to be on the core economic decisions and incentives that building owners respond to. It also helps support our viewpoint that generally speaking, markets have worked; there are rational, explainable reasons why building owners either don’t see bills lying on the ground or dont think it worth the time and effort to bend down and pick them up.

When laid out like this, it also makes clear that overcoming these barriers isn’t all that hard. It really all comes down to a farily simple question: how do we cut through complexity and create incentives that get the building owner on board? Once that question is sorted out, then the old economists might finally be right – there probably won’t be many $20 bills left on the street.

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New York State recently passed a law that would allow for New York buildings to access on-bill financing to fund retrofits, which is expected to be signed into law by Governor Cuomo. On-bill financing is a mechanism that allows buildings to borrow the upfront capital needed for a retrofit from a utility and pay the loan back over time via an additional change on the normal monthly utility bill, hence the name “on-bill financing”.

Our friend Fred Fucci and his colleagues at Arnold Porter have put together a publicly available overview that gives much more detail on the workings of the program.

On-bill financing isn’t all that different from PACE financing, but uses the utility instead of a municipality as the source of capital for the retrofit. On-bill financing has a number of important features that make it an attractive way for financing retrofits:

The financing arrangement stays with the building. If the building is sold, the new buyer simply assumes responsibility for paying the loan back to the utility. Buyers of real estate are very skilled at assessing these types or arrangements, which means on-bill financing poses little to no risk to existing building owners in the event of a sale

On-bill financing does not require a first priority lien on the building. Unlike PACE, where Fannie and Freddie effectively scuttled the program based on their concern about superpriority tax liens coming ahead of existing mortgages, on-bill financing would have a lien junior to the existing or future mortgage. This works much better from the existing lenders perspective of course, but also works well for the utility: the utility retains significant security via their ability to “turn off the switch” if the building does not make payments on the loan.

What is the takeaway?

We view this new law as a huge step forward for the energy efficiency finance market in NY State. Utilities providing cheap capital for retrofit projects will certainly help fill the funding gaps that rebates and incentives leave behind.

Psychologically, there may also be some benefit to having the utility as the source of financing. Versus some of the independent energy efficiency financing companies, the utility is certainly perceived as a much stronger counterparty, which may provide some additional comfort from the building owner’s perspective.

And as we’ve often described here at Financing Efficiency, our core belief is that retrofits are entirely dependent on real estate – i.e. building owners and managers hold the keys to achieving scale in the retrofit market. The success of the on-bill financing program, therefore, will depend on how strongly building owners respond to it.

We also spoke with Brad Copithorne, an energy efficiency finance expert with the Environmental Defense Fund. Brad applauded the work being done in New York, and suggested possible pathways for further improving the quality of the program. In particular, commercial banks could provide the financing instead of NYSERDA, a state research organization. By using third party capital an even broader range of transactions might be financed. In this model, the utility would act only as the payment processor, which is a service the utilities are already effectively providing. Banks would then be responsible for providing the loan capital and establishing the underwriting criteria. There are also open questions as to whether on-bill financing could be considered off-balance sheet.

We believe the New York bill is a promising start, but it remains an open question whether on-bill financing will successfully play a large role in financing retrofits at scale. It is now up to real estate to decide what type of energy efficiency financing mechanisms they want to engage with.

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One of the persistent questions we hear when discussing energy efficiency is “What about ESCOs? Why can’t they just do all of this stuff?”

It seems that there is a disconnect between what Energy Services Companies (”ESCOs”) actually provide to building owners and what many in the market think they provide. Understanding the nature of what ESCOs do will help the market to better understand the requirements for future solutions.

What do ESCOs actually do?

ESCOs sell, design, and manage energy efficiency projects. They often provide a long-term performance guarantee to a building owner, which gives the building owner comfort that the forecasted savings will be achieved from a technical perspective. Other important variables that drive potential savings, such as operations of the building or the mix of tenants, are not covered. Basically, the ESCO just provides a guarantee that the equipment will work as expected. In some cases, the ESCO will actually operate the project over the long term, too, which helps to minimize the operational risk of a project.

It’s worth noting that many of the largest ESCOs also own equipment manufacturing companies. As we mentioned in our last post on the ESCO industry, many ESCOs are viewed by their corporate parents almost purely as another channel to sell equipment. Case in point: the acquisition of YORK by Johnson Controls in late 2005 helps to highlight the degree to which ESCOs are focused on selling equipment as a primary concern.

One thing ESCOs generally do not do, however, is provide financing for projects they are involved in.

The ESCO generally expects to be paid for its work at the completion of the project. This means that the building owner / project host needs to have the full amount of capital on hand at completion to pay the ESCO. Some owners – the very small minority – will just pay outright for the project. However, the vast majority of owners involved in projects with ESCOs will have to source third party capital for the projects.

Financing considerations

In almost all cases, this capital will take the form of traditional corporate / parent entity level debt. To be more explicit, third party financing virtually never lends directly against the energy savings produced by a retrofit project.

Because so many ESCO deals are in the MUSH (municipal, university, school and hospital) sector, this financing is often sourced from the municipal finance desks of banks. Issuing debt to fund a retrofit is no different from issuing debt to fund anything else a municipality might want to invest in. The key variable that a lender would evaluate is the municipality’s overall credit quality, not the guarantee from the ESCO.

The key question of whether capital is available for the “ESCO model” is not whether a performance guarantee is in place but rather whether the host is willing to assume additional debt at the parent entity level. Virtually all energy efficiency deals that are financed by a third-party rather than paid for by the host owner require a credit worthy recipient of debt.

If a building owner is sufficiently creditworthy and is willing to guarantee that payments will be made regardless of project performance, then there is little reason for a financial institution not to provide financing.

Without an ESCO guarantee, the bank is likely still comfortable that the debt will be repaid due to the host’s credit quality and the nature of the debt which has recourse to the host’s assets. All the ESCO’s performance guarantee does is to help the host get comfortable that it will have funds available to service the debt. Banks may prefer to lend to projects that are managed by leading ESCOs, but this is likely due to avoiding scenarios where litigation or other complications occur. The bank only sees a creditworthy entity taking on more debt.

Building owners can also use an ESCO for project management of energy efficiency retrofits and to provide a guarantee. The financing would then be sourced elsewhere. This is how the Empire State Building retrofit worked, for example – Johnson Controls managed the project and provided a guarantee, but the building’s owner Tony Malkin put down the money for the project. In that structure, Malkin was basically just buying insurance from the ESCO that the project will perform as expected.

ESCOs are great, but can’t solve everything

ESCOs provide a valuable function in the market. They offer expert engineering services, performance guarantees for projects, and integrated project management services. However, they are not a one-size-fits-all solution to the barriers preventing private building owners from pursuing energy efficiency. Understanding exactly what an ESCO does – designing, selling, and managing project, possibly with a performance guarantee – is useful. They do not guarantee to provide payments to lenders, and they do not offer financing directly to building owners themselves.

So while ESCOs play a large and beneficial role in energy efficiency today, new financing mechanisms and business models beyond the ESCO will need to emerge in order to scale retrofit investment in private real estate.

Our friends at Transcend are the pioneers of the Managed Energy Services Agreement, or MESA, which allows for third-party capital investment in retrofit projects without taking liens on the property or otherwise requiring general building level debt. Transcend’s investment is paid back through energy savings over the period of the MESA contract.

The MESA is one example of innovative off-balance sheet financing mechanisms we discussed previously. As we described in our post, Mind the GAAP, we believe that off-balance sheet financing is critical to scaling building energy efficiency. Transcend has used this model in a large number of projects to date. The JV with Mitsui will allow Transcend to engage on many more projects in the coming months and years. Importantly, the Transcend – Mitsui JV may also pave the way for development of larger retrofit investment funds.

In other Transcend-related news this past week, a consortium consisting of Transcend, Forsyth Street Advisors, and PositivEnergy Practice were awarded $9 million in federal funds for loan loss reserves for energy efficiency retrofit projects in the Chicago area. This will presumably allow Transcend to use debt to fund a portion of the investments it makes in projects, allowing the firm to stretch the Mitsui JV even further.

Congrats to Transcend on the great news. We will have a lot more to say on Transcend in the coming weeks.

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We wanted to feature a small milestone in the development of one of our favorite firms in the energy efficiency space. Carbon Lighthouse, founded by friends of this blog Raphael Rosen and Brenden Millstein, recently won a spot as one of the 2011 Echoing Green Fellows. They are one of 15 fellows selected from among 38 finalists. Echoing Green is a non-profit which backs social entrepreneurs developing visionary “solutions to society’s most difficult problems.” Echoing Green has helped to invest $30 million dollars in seed funding for 500 social entrepreneurs.

Bold Idea: Take on global climate change, at a meaningful scale, by building a one-stop-shop for companies to eliminate their entire carbon footprint.

Organization: Carbon Lighthouse will enable consumers and corporations across the globe to profitably eliminate their carbon footprints. By combining four existing technologies—energy efficiency, demand response, renewable energy, and carbon allowances into a single financed package, Carbon Lighthouse eliminates the upfront costs, transaction costs, and redundant engineering/contracting currently preventing corporations from profitably eliminating their carbon footprint.

We’d also recommend you check out Carbon Lighthouse’s incredibly informative blog which features articles on wonderful energy efficiency topics like economizers, measurement and verification techniques, and the physics of how a room is heated.

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As discussed in our last post, the returns currently available from retrofit projects appear to provide more than enough return to offset the risks of such projects. What then is holding retrofits back?

In order to understand the current state of the energy efficiency market, we think that the definition of risk must be expanded slightly. As generally defined, investors tend to think of risk purely in the context of whether potential returns justify the risks inherent in an investment. What we should be asking is, “are these investments worthwhile for the building owner?”

This broader definition of risk for building energy efficiency points at many of the reasons that retrofits do not happen – the barriers facing building owners – rather than the implied financial risk inherent in executing the individual projects. Three of the core issues that are creating barriers for building owners are: (1) can the building owner recover her invested capital, (2) retrofits are potentially very time consuming, and (3) retrofits are generally outside the core focus of the owner.

The split incentive is real. Arguably the single largest reason that efficiency retrofits do not occur today in the privately owned real estate market is the split incentive. Under a large portion of commercial leases, building owners are responsible for capital investments, and tenants reap the benefits of operating expense reductions. Triple net leases, often abbreviated as NNN leases, indicate that all expenses are passed through to the tenants. In many cases, owners literally can’t recover the money invested in retrofits. There is no risk to assess, because there is often no chance of returns.

But even putting aside the split incentive, when a building owner looks at a 12 to 15% return on a building energy efficiency retrofit, the basic reaction is not “hey, 12 to 15% return sounds pretty attractive, and not too risky. Where do I sign up?” Rather it’s generally “gee, 12 to 15% sounds intriguing but my core business is owning real estate and making my asset as valuable as possible, and that primarily means attracting and retaining tenants. All this energy efficiency stuff seems like a questionable use of my valuable time, and would require a lot of effort for me to learn about how building energy efficiency retrofits work.” What the building owner is implicitly saying is that 12 to 15% is attractive, but probably isn’t worth the time and effort needed to actually make it happen. Culturally, building owners tend to look mostly at investments that will directly result in higher rent or increased occupancy by higher quality tenants. Although there are many indications that energy efficiency retrofits will help to do this, there is not yet a robust and statistically sound set of data to prove the hypothesis. Additionally, building owners tend not to attempt to pioneer new techniques, so building retrofits go undone in the face of more traditional investments like lobby renovations.

To compound matters, the opportunity from energy efficiency retrofits represents a relatively small portion of a buildings’ total operating profile. In a standard building, energy expenses might be only 2-4% of the building’s total operating expenses. In some cases, this may stretch to 10%+, but it is generally not considered to be a major line item by most property owners. Unfortunately, great returns on a tiny base don’t matter to many owners. If energy costs are reduced by 30%, and they make up 4% of annual expenses, this only represents a total reduction in building level expenses of 1.2% percentage points. Nice, yes, but must have? Depending on the time and effort involved, the answer from building answers is often “no”. It’s also worth noting that many buildings are owned to produce steady, stable, low-risk income. Building owners and investors as a class are notoriously risk adverse. Many are currently unwilling to jeopardize the current set of cashflows through a seemingly intrusive retrofit, even if that investment presents a compelling economic opportunity.

What does this mean for building energy efficiency investments?

Appropriately understanding the actual challenges facing the adoption of energy efficiency investments makes it significantly easier for the industry to determine the nature of viable solutions. This fact underscores one of our fundamental hypotheses –that retrofits are about real estate. Without the real estate component of the deal, there is no retrofit. As an industry, we need to focus on the building owners and deliver solutions to them that both meet their needs and are presented in their language.

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Of course, a big element of any investment is determining the actual level of risk. When a big pension fund acquires a class A commercial space at a 6% cap rate, they’re implicitly saying that the risks of such an investment are commensurate with the likely rate of return on that property. For those not in the industry, the capitalization rate, or cap rate, equals the annual net operating income divided by the value of the real estate asset. It is a commonly used metric for understanding and comparing the different implied valuations of various properties. It can also be thought of as the reciprocal of a valuation multiple. A 5% cap rate implies a 20x NOI multiple, while a 10% cap rate implies 10x.

So although the thought of a retrofit project that can return 10 to 15% on an unlevered basis sounds attractive relative to the returns for most core real estate assets, which tend to generate between 6.5 and 7.5%, we know from market statistics that these investments are not being made en masse. Armed with basic finance theory, this tells us that investors (the seemingly natural retrofit investor being building owners) may view investments in energy efficiency as risky and thus require a higher level of return than even the rather impressive potential 10 to 15% returns that we believe these investments can currently offer on an unlevered basis.

But are these retrofits really risky? After all, the potential 10 to 15% return on an energy efficiency investment is significantly greater than what large cap equities generally return, and far more than even the junkiest of CCC-rated junk bond issuances, which can issue 10 year unsecured paper in the 9% area. Can it really be that retrofits are SO risky that they require distressed levels of return to make these investments worth the level of risk?